Speculative investors take profits and run

Commodities have become highly volatile even by historical standards, at one stage crashing by over 25 per cent in the week Osama bin Laden was killed in May, a reality check after months of surging prices.

That sell-off was prompted by growing evidence that the American economy has stalled, and while there is near consensus that the long-term fundamentals remain intact for a prolonged bull market, in the short-term slowing growth is the critical concern.

“At even moderate global growth rates we could be entering the kind of bull market for commodities we saw in the energy crises of the 1970s,” says Peter Csoregh, fund manager of Robeco Natural Resources Equities.

“But growth is very uncertain at this point, with a long list of problems looming on the horizon ranging from an end to fiscal stimulus in much of the world, to spiking oil prices due to the Middle East crisis. And if growth starts to falter we will have severe problems because authorities have run out of bullets on both the fiscal and the monetary side,” he explains.

“The volatility we have recently seen in commodity markets is a reflection of the binary nature of these two realities. With record long speculative positions in things like Nymex crude, any price moves get amplified as investors shift from one leg to the other,” adds Mr Csoregh.

Excessive speculation has also increased volatility in precious metals markets, where some of silver’s mid-May rebound was due to big investors closing out short positions. At its most basic level, customers in the real economy will reduce their demand for a commodity when its price rises, but the opposite happens where financial speculators drive up the price and then step out once it starts turning downwards.

“We see the primary driver of the recent commodity price declines as, initially, retail and non-traditional commodity investors taking profit on gains and subsequently the activation of stop-losses as prices declined,” says Jeff Holland, managing director at Liongate Capital Management.

“Commodities, especially recently, have been prone to unsophisticated speculative inflows chasing returns, driving prices higher faster and then washing out on no particular news when the trade becomes too crowded,” he adds.

Holdings in commodity funds have been hit, with substantial switching to money market and bond funds. Commodity funds tracked by EPFR experienced record outflows of $2.3bn (€1.6bn) for the second consecutive week in early May. Gold and precious metals funds bore the brunt, as a combination of profit taking, and higher margin requirements took their toll. Energy funds held up better as investors focused on tighter supplies rather than softer demand.

Long-term trends

On any long-term view, the bulls win outright, however. “We anticipate a long and sustained period of above average trend growth and demand for a wide range of commodities, of the type we saw in Japan in the 1960s, but Japan has only 120m people – tiny compared with China’s 1.2bn,” says David Field, fund manager at Carmignac Gestion.

“We believe the sheer scale of China’s population will have a longer term effect on commodity demand than some commentators give it credit for.”

“Chinese oil consumption has to rise,” agrees Richard Davis, portfolio manager in BlackRock’s natural resources equity team. “It is currently similar to the US in 1910. Or if you take copper, Chinese consumption is currently 5 kilos per person, but in the Western economy it is 15 kilos per person.”

On the supply side, there has been a massive under-investment in mining infrastructure over a 20-year period. Exploration has been poor, with no major finds in oil, copper or gold. Mining companies have cherry-picked their mines, and in 2008, many remaining projects suddenly lost their financing. The knock-on impact on successful mining stocks will be a boost in M&A activity, and higher dividends and share buybacks for shareholders.

The 18m tonne copper market is a perfect example of supply problems combined with robust demand. Existing mines face 4 per cent degradation per year, a deficit of some 400-500,000 tonnes in the next five months. No substantial new projects will be on stream until 2015.

“Miners have taken action such as firing skilled staff and removing themselves from queues for new equipment,” adds Carmignac Gestion’s Mr Field.

“In the copper market for instance, 1.5-2m tonnes in new supply has been lost compared with the growth that had been expected to come on stream in 2007. This is effectively taking 7-10 per cent of the growth out of the market. Supply will struggle to keep up for at least five to seven years.”

“Some of these industries are highly concentrated, such as iron ore, which is dominated by three producers, Rio, Vale and BHP,” adds Mr Davis at BlackRock. “This is where the pricing power is. Consumers are the price-takers and these suppliers are the price-makers.”

There is also consensus around oil. Mines are yielding 6-7 per cent less than last year. Opec has 4m barrels of spare capacity a day, and demand last year increased by 2.9m barrels per day. Many thought this year it would fall to around 1.5m, but it has remained constant at last year’s level, so in 18-24 months conditions could be very tight in oil markets, and there is the risk Opec is overstating capacity to maintain credit ratings.

There are also specific opportunities, such as uranium, where sentiment has become bearish but dozens of nuclear power stations are being built with far superior technology to the crippled 40-year-old Fukushima plant. The case remains that 20 per cent of all electricity in the US is generated by nuclear power, and that it will benefit from being market driven rather than quasi-governmental.

China faces a pressing need to converge in terms of emissions. Platinum, used in catalytic converters, is predicted to rise as supply problems have been exacerbated by political issues in South Africa and Zimbabwe.

As the world’s most populous nation moves on from producing cheap standard cars to a more sophisticated western model, demand for zinc to make corrosive-resistant frames will also rise. There is also a critical shortage of mineral sands, used in metallic car paint which is catching on across Asia.

Rare earth metals, the group of 17 rare metals used in high tech such as guidance systems for cruise missiles, are in strong demand but as they are used for small components in expensive items any price rise will not impact the end-product pricing too critically. China’s near monopoly has effectively knocked out much of the market-based competition, leaving only five new projects globally.

NO GUARANTEES

The $65m question is whether prices can continue to rise in the short or medium-term, after such a fantastic run in the last few years. “Commodities have already moved so much, we don’t believe they can rise much in future,” says Gary Potter, who runs a diversified FOF portfolio at Thames River.

“Long-term the outlook is favourable, but people should not forget that everything has its price; investment is all about what you pay and when you pay it. Growth is picking up but it is anaemic in the west and slowing down in the east. Investors should not be naïve, but give due deference to where commodities have come from.”

However, fund managers stress that the market is less than perfect, and there are opportunities to be manipulated. “Many people think our investment universe is just a tightly correlated set of energy and mining stocks, when it actually extends well beyond the primary producers to include downstream processing and parallel value chains in areas like forest products and building materials; we also consider engineers, service companies, shippers and makers of alternative energy equipment,” says Ruairidh Stewart, co-manager, Martin Currie Global Resources Fund.

“It is often assumed that ‘it’s all about the oil price’, but even oil companies – never mind the many other, less correlated areas of our universe – can outperform the wider market when the price of the commodity falls through the floor,” he explains.

“But perhaps the biggest misconception is that publically available information is factored into share prices quickly and efficiently. It is not. We repeatedly find examples of data being ignored or interpreted differently across regions and sectors, probably because of narrow specialisation and poor communication in large institutions.”

Simplistically, if the commodities universe is broken down into those used for building emerging economy infrastructure such as copper, and those in demand from the western world such as oil, then precious metals, which are seen as a hedge against inflation and as a store of value in the current geopolitical turmoil, could also move independently.

Their bounce back is being driven by the latest chapter in the Eurozone debt crisis, with S&P’s decision to downgrade Greece again, to B, the turning point. If the US Federal Reserve now continues with monetary easing post QE2 this will be bullish for gold and silver, so we can conclude that the events that triggered a decline in commodities could in fact prove positive for precious metals.

Equity-related commodity funds  often inefficient

Commodity-focused ETFs (exchange traded funds) generally underperform compared with active investors who can gain a consistent edge in derivatives markets, such as by buying futures ahead of the big programmed rolls which drive up the price and selling contracts before the trackers do.

However, funds investing in commodity-related equities also have inherent weaknesses, according to David Stewart, group CIO, Bank of Butterfield.

“Irrespective of what one thinks about the attractions of investing in commodities, the problem with most third party funds is that you are investing in related equities, whose medium-term value is partly predicated by the underlying commodities but also represents exposure to mining companies’ managements, who as a rule are very poor.”

Mr Stewart also points out a fund will always be a basket of assets, and there is a real risk a fund manager may be investing with a different macro outlook than the private bank’s. “Gold funds in particular could be one of those elements where there are inconsistencies,” he says.

“The onset of the New Cold War in the Middle East means the next oil shock is a question of when and not if, irrespective of the short-term price,” believes Mr Stewart, adding that “markets are good at extrapolating linear progression, but not at pricing in a discontinuous shift.”

This means oil is problematic, he says. “It’s the very definition of tail risk and inherently unhedgeable. How do you hedge oil at $200? The last thing you want to do is to invest blindly in an oil ETF. But we can be very confident oil will get to $150, because logically it has to before it can get to $200,” says Mr Stewart.

“Exposure to oil is made more difficult because much of the new oil being discovered is in ‘thugocracies’ around the world, regions where Western oil companies find it difficult to compete due to career and corporate risk.”

US, French and UK managers have all faced risks trying to cut business deals with government officials in these countries, he explains. “But the case for investing in oil seems a separate argument to that for a lot of commodities, which is just doubling up on the ‘China’ story,” adds Mr Stewart.

Investors also need to watch the dollar. “Euro investors should to be cautious and mindful of US dollar developments as a weaker US dollar may reduce, or even undo, the positive performance of commodities,” says Peter Königbauer, senior portfolio manager, Pioneer Funds Commodity Alpha.

“Therefore these investors should consider at least a partial currency hedge,” he says.

VIEW FROM MORNINGSTAR

Similar objectives, different strategies

While world markets (MSCI World index) were returning to investors less than 6 per cent in euro terms over one year to 5th May 2011, funds in the Morningstar Equity Natural Resources GIF sector were yielding an average of 12.6 per cent.

One of the best performers in the sector is the BGF World Mining fund, especially over the longer term. It has been awarded an “Elite” rating by Morningstar’s qualitative research team and that’s not only thanks to its long-term returns. Indeed this fund is run by an experienced team, offers an excellent level of transparency, and its portfolio construction has been consistent since its launch in 1997.

Despite their many appealing features for investors, one shouldn’t, however, forget the high level of volatility attached to natural resources funds or their heterogeneity in terms of strategies and returns.

How can such differences be explained? First of all, natural resources funds don’t invest directly in commodities or commodities indices; they invest in listed stocks, whose prices are impacted by natural resources prices, but not in a linear manner. In addition, these listed stocks are essentially mining companies, gold companies or oil producers. With the exception of very few markets such as Australia, one hardly finds stocks involved in agriculture.

And finally, there are important differences within natural resources themselves: precious metals funds, for example, took more than 14 per cent over one year, when energy funds returned just over half of that.

Frederic Lorenzini, director of research, Morningstar France